Estimating valuations of investments held by a private equity fund is a notoriously subjective and difficult business. There is some academic evidence that this inherent subjectivity is exploited by managers on the fund-raising trail, and regulators are beginning to pay a lot more attention to how valuation estimates are developed. So, although they are rarely
used to determine pay-outs of carried interest, investors are understandably keen to ensure that valuations are robust and consistent, allowing them to make judgements based on the information they receive. That means that industry standard valuation guidelines are very important, and for some years now these have been overseen by IPEV, an international body whose prescriptions command widespread acceptance in Europe (and increasingly so elsewhere).
In the past, fund managers would account for investments at cost, which was seen as objective, conservative and easy to determine. But investors have increasingly required fund reporting to be prepared on a fair value basis and this approach is now near-universal. That requirement puts significant pressure on the valuation methodology used, and regular reviews of the IPEV guidelines are needed to make sure they keep pace with changes in best practice. To that end, the IPEV Board is seeking
comments on its latest revisions by next Friday (27 November), following its first review since 2012.
As it happens, this time there are no major changes proposed. The guidelines have been restructured to make them more readable, there is a new section on non-control investments – explaining when it would not be appropriate to use the enterprise value of the investment as the starting point in establishing fair value – and some new text on how to value debt which has a pre-payment penalty, and these are helpful clarifications. There is also now less negativity towards the use of discounted
cash flow (DCF) and financial models which reflects trends in the US to make greater use of them. However, these methods include significant subjectivity, and (unless cash flows can be predicted with reasonable certainty, as with a mezzanine loan) are only generally used by European managers either as a "cross-check" or when other methods are not appropriate.
Of interest to investors and managers will be the explicit introduction of "backtesting", meaning that prices achieved on exit are compared with previously reported values. Although investors are increasingly doing this exercise themselves, IPEV requires valuers to seek to understand the reasons for any material differences, and to use these to inform future valuations.
All in all, these changes are sensible developments of the guidelines, which will require some incremental changes to practice but broadly confirm that the IPEV guidelines remain consistent with how market participants approach valuation estimates. In this context, the industry should take note of a project currently in progress at the American Institute of CPAs (AICPA, the US accountants' membership association) which is aiming to develop detailed guidance on fair value estimates for unquoted companies. An exposure draft of their recommendations is expected later this year, and it will be important that this guidance is consistent with that established by IPEV.
We gratefully acknowledge assistance from Iain Bannatyne at KPMG in the preparation of this edition of Private Equity Comment. Iain is speaking on the IPEV guidelines consultation at next week's BVCA Tax, Legal and Regulatory Conference in London – for more information please click here.